Active vs Passive: Which Investing Approach Is Right For You? (2024)

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Active vs Passive: Which Investing Approach Is Right For You? (1)

The relative merits of ‘active’ versus ‘passive’ investing are hotly-debated.

Active fund managers argue that their higher fees are more than offset by index-beating returns. Passive fund managers point to only a small number of active funds managing to beat their passive counterparts over a period of five years or more.

We’re going to explore what investors need to know about active and passive investing in order to maximise potential returns. We’re also going to look beyond the glossy marketing to see whether active investing has actually outperformed the passive approach.

Remember: investment is speculative. Your investment can go down as well as up, and you lose some, or all, of your money. You should consider seeking financial advice before deciding whether to invest.

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What’s the difference between active and passive investing?

  • Objective: active investments aim to ‘beat the market’ whereas passive investments track an index (hence they’re referred to as tracker or index funds)
  • Technique: active fund managers pick the shares while passive investment vehicles replicate the composition of an index (for example, by buying shares in all the companies listed on the FTSE 100 in proportion to their relative market capitalisation)
  • Rationale: passive funds are based on the concept that markets are efficient and accurately priced. Active fund managers believe markets can be inefficient, creating opportunities to find mispriced and undervalued companies.

Both active and passive collective investment products pool money from investors to be invested by a fund manager in a basket of shares or other assets.

Pros of active funds

  • Potential: active fund managers try to ‘beat the market’ rather than replicate the average return for a particular index
  • Flexibility: active funds have more freedom in their choice of investments. For example, investors seeking ethical investments can choose an ESG (environmental, social and governance) fund
  • Protection: active managers limit losses in falling markets by increasing their allocation of cash or lower-risk assets. They can also protect against geopolitical or sector-specific risks, for example, by moving investments out of a particular country.

Cons of active funds

  • Higher fees: active funds charge high fees to cover the expertise and resources they require. According to trading platform AJ Bell, the average annual fee in the UK All Companies sector was 0.86% for active funds, compared to 0.17% for passive funds
  • Performance: the performance of the fund depends on the skill of the manager. Fund managers aim to outperform the index, which may result in their making higher-risk choices
  • Volatility: the fund may hold a smaller number of investments relative to an index tracker. This can increase volatility as performance is dependent on a concentrated basket of shares.

Pros of passive funds

  • Lower fees: passive funds typically charge lower fees than their active counterparts as replicating an index is more straightforward than stock-picking. According to Morningstar, 90% of passive funds charge an annual fee of less than 0.5%, compared to only 13% of active funds.
  • Less reliance on fund manager: investors are not reliant on the stock-picking skills of the fund manager and will receive the average return for the index as a whole.
  • Decreased risk: depending on the index, passive funds will invest in hundreds of shares. This provides investors with a well-diversified portfolio and lessens the risk of reduced returns from individual shares underperforming.
  • Transparency: investors know the underlying holdings of passive funds as they are the constituents of the relevant index. There is less transparency for active funds as fund managers are less keen to reveal their underlying investments.

Cons of passive funds

  • No scope for outperformance: although investors may be able to generate higher returns by tracking one index over another, they lose the potential to outperform the index.
  • Limited protection in market downturns: passive funds cannot reallocate their portfolio to protect against potential losses, for example, holding a higher proportion of cash or investing more defensively.
  • Concentration: passive funds are weighted by the market capitalisation of the companies in the index. This can result in the performance – good or bad – of a small number of companies having a disproportionate impact on the overall performance of the fund. For example, Apple accounts for 11% of the S&P 100, with the top 10 companies representing 43% of the overall weighting of the index, according to S&P Global.
  • Lack of flexibility: passive funds may offer a limited choice for investors wanting to invest in certain sectors, such as ESG.

Have active funds outperformed passives?

The crux of the debate centres around whether active funds have justified their higher fees by outperforming their passive counterparts.

This can be split into two parts: the proportion of active funds that have outperformed, and their degree of outperformance.

1. Proportion of ‘out-performing’ active funds

The table below shows the percentage of active funds that have outperformed their passive peers, based on total returns for the 10-year period ending December 2021.

SectorProportion of outperforming active funds
Global emerging markets72%
Europe (ex UK)64%
Asia Pacific (ex Japan)63%
North America22%
Source: AJ Bell

Active funds have fared most poorly in the North America and Global sectors, with only 22% and 30% respectively of active funds beating passive funds. This is partly due to the US sector being well-covered in terms of research, which makes it harder for fund managers to find ‘bargains’.

North American fund managers also face the difficult decision of whether or not to invest in the technology giants that have delivered high returns over the last decade, with the risk that they end up becoming a quasi-tracker fund.

These stocks have a disproportionate weighting in both US and global funds, and their associated returns, due to their high market capitalisations.

The UK has been a happier hunting ground for active fund managers, with 85% of active funds outperforming. Many of these funds invest in small and mid-cap companies, where there’s more opportunity for stock-picking and the potential for higher returns.

2. Degree of outperformance

It’s also important to look at the margin by which active funds outperform passives:

SectorActive returns Passive returnsDifference
Global emerging markets115%91%+24%
Asia Pacific (ex Japan)166%143%+23%
Europe (ex UK)202%185%+17%
North America353%404%-51%
Source: AJ Bell, 10-year total returns

As expected, the North American and Global active funds achieved a lower average return than passives, although it’s worth noting that the active funds here delivered by far the highest returns of all sectors.

Clearly it isn’t always possible to pick the best-performing fund, but active funds have the potential to deliver far higher returns to investors. That said, not all active funds justify their higher management fee in terms of outperforming passive funds, particularly in certain sectors.

What types of active and passive investments are available?

These are the two most popular types of actively-managed investments:

  • Funds (also known as Open-Ended Investment Companies or OEICs): these are the most common actively-managed products bought by investors. They cover a variety of sectors, geographies and assets.
  • Investment trusts: these are another actively-managed option which pools investors’ money to buy a basket of underlying shares or assets. One of the main differences to funds is that investment trusts are allowed to retain 15% of annual income in a ‘rainy day’ reserve, allowing them to maintain a constant dividend stream in market downturns.

Similarly, there are two main types of passively-managed investments:

  • Funds: passively-managed funds track an index, such as the FTSE 100 or S&P Global 500.
  • Exchange-traded funds (ETFs): Like passive funds, they track an index, but they can be bought and sold throughout the day, rather than once a day as for funds.

Should you invest in active or passive funds?

The simple answer is that there’s a place for both types of investment as part of a balanced portfolio.

Based on past performance (which is not a guide to future performance), investors might want to look at passive funds for exposure to the North American and global sectors. These provide a low-cost way for investors to benefit from an overall rise in the stock market.

Active funds have more of a role to play in other sectors, particularly in the UK and emerging markets. Fund managers have more opportunity to use their research skills to find high-growth companies, or potentially undervalued companies, in these markets.

Both Morningstar and Trustnet provide data benchmarking active and passive funds and ETFs against their peers. These are a useful resource for investors wanting to compare funds across different types and sectors.

However, investors should look for funds that consistently perform in the top quartile against their peers over three years or more, rather than falling into the trap of investing in ‘last year’s winners’.

It’s also worth comparing the best trading platforms for your portfolio as the range of investments and fees can vary significantly.

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Now, let's dive into the concepts discussed in the article about active and passive investing:

Active vs. Passive Investing:

1. Objective:

  • Active: Aims to 'beat the market.'
  • Passive: Tracks an index.

2. Technique:

  • Active: Involves fund managers picking specific shares.
  • Passive: Replicates the composition of an index.

3. Rationale:

  • Active: Believes in market inefficiencies, seeking mispriced opportunities.
  • Passive: Based on the efficiency of markets, assuming accurate pricing.

4. Collective Investment:

  • Both involve pooling money from investors to be managed by a fund manager.

Pros and Cons:

Active Funds:

  • Pros:

    • Potential to outperform the market.
    • Flexibility in investment choices.
    • Ability to limit losses in falling markets.
  • Cons:

    • Higher fees compared to passive funds.
    • Performance relies on the skill of the manager.
    • Increased volatility due to concentrated holdings.

Passive Funds:

  • Pros:

    • Lower fees.
    • Less reliance on fund manager skills.
    • Diversified portfolio, reducing individual stock risk.
  • Cons:

    • No potential for outperformance.
    • Limited protection in market downturns.
    • Concentration risk based on market capitalization.

Active Funds Performance:

1. Proportion of Outperforming Active Funds (10-year period ending Dec 2021):

  • UK: 85%
  • Global Emerging Markets: 72%
  • Europe (ex UK): 64%
  • Asia Pacific (ex Japan): 63%
  • Global: 30%
  • North America: 22%

2. Degree of Outperformance:

  • Varies across sectors, with the UK having a significant outperformance.

Types of Investments:

Actively Managed:

  • Funds (OEICs): Commonly bought products covering various sectors.
  • Investment Trusts: Retain a 'rainy day' reserve for consistent dividends.

Passively Managed:

  • Funds: Track indices like FTSE 100 or S&P Global 500.
  • ETFs: Tradable throughout the day, also tracking indices.

Choosing Between Active and Passive:

  • Past Performance Analysis:

    • Passive funds for exposure to North American and global sectors.
    • Active funds in the UK and emerging markets for potential high returns.
  • Considerations:

    • Look for consistent top quartile performance over three years or more.
    • Compare trading platforms for varied investments and fees.

In conclusion, both active and passive investments have their places in a balanced portfolio, and the choice depends on individual preferences, risk tolerance, and market exposure goals. It's crucial to stay informed and consider historical performance along with future expectations when making investment decisions.

Active vs Passive: Which Investing Approach Is Right For You? (2024)
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